HOTELoC is under credit watch following a press release by Morgan Stanley concerning the Orb Group's business woes. According to market sources, there is an ongoing investigation by the English Serious Fraud Office into certain members of the group. An investigation by Ernst & Young and Morgan Stanley found a shortfall in the cash flows within the transaction. "The pertinent question here is what's happened to the missing funds?" asked one analyst.

The notes in the transaction are backed by a single loan from Morgan Stanley Dean Witter to Jersey-based Hotel Portfolio II and the U.K.-based Hotel Portfolio II - both members of the Orb Group of companies. The loan is secured on hotel assets owned by the Orb Group that are leased back to Thistle Hotels. At present, the Orb Group has defaulted on the two loans from Morgan Stanley Dean Witter and is looking to exit the hotel business.

The current situation with HOTELoC is likely just a one-off quandary, but it still highlights the ongoing peril of single obligor concentrations in a tricky corporate credit environment. "I don't think that the situation highlights any broad trends developing in the CMBS sector, although as the market matures, problem loans are bound to surface from time to time," said one market analyst. "In this case, it is a borrower problem. We have been saying all along that the aim should be for more diversification of borrower pools, and if you are concentrated with one borrower, then investors should exercise more scrutiny on the borrower and the corporate credit quality along with the traditional focus on the quality of the property."

With hotel properties long out of favor in CMBS transactions - coupled with the uncertainty following the decision of the Orb Group to exit the hotel business - market sources say that it's probably a positive for the HOTELoC transaction that the Orb group will be removed from the equation. With the single borrower, again, it's a similar issue to that which occurs in any sale/lease-back - the ratings of the bonds can be more volatile than a multi-borrower pool. Transactions related to a single tenant are often subject to volatility comparable to the tenant's related corporate debt, one source said.

"The missing GBP11 million would have to be repaid higher up in the waterfall, so it potentially affects all the notes," explained one market source. "It really all depends on what the new owner will do; whether it will develop the hotels into alternative properties (high-end apartments) and, if so, what the potential for high-end properties is in the current environment."

Moody's Investors Service advanced rating for the class D and class E notes were based on the ownership potential of three of the largest properties included in the portfolio located in London. These properties were slated for conversion into high-end apartments, but with ownership changing hands, the rating agency will have to monitor to what extent the de-levering of the transaction from disposal proceeds of the three properties may be impacted.

Moody's has stated that if the funding shortfall is not addressed by the end of this month the borrower will be in breach of its obligations under its operating and credit agreements with Thistle. The rating agency added that the shortfall would then be reviewed in context of the breach and the overall resolution to the current circumstance. Standard & Poor's has likewise placed the notes on negative watch.

And the questions don't stop there. Earlier this week, market headlines indicated that the group's failure to pay interest and an amortization reserve payment might spell trouble for the ELOC 8 transaction as well. Orb Commercial Ltd and Orb Warehousing Ltd, both subsidiaries of the Orb Group, failed to make loan interest payments in the transaction and did not replenish the escrow account.

According to Dresdner Kleinwort Wasserstein, the interest was paid from this escrow account, which currently holds approximately $3.16 million (equivalent) and is available for drawing against shortfalls in principal and interest payments. Though the loan is not currently in interest arrears, it has been declared in default and is now being specially serviced by Morgan Stanley Mortgage Service Ltd. The defaulted loan is among the 10 commercial mortgage loans in the portfolio, but it represents a significant aggregate portion.

Both Fitch Ratings and S&P have placed the triple-B rating of the class E notes and the double-B rating of the class F notes on rating watch negative, but market sources question whether the single-A rating of the class D notes might eventually come under review as the situation is unveiled. "Although the agencies have looked into the transaction in some detail, if the Orb subsidiary tenants do not perform, and there is difficulty in finding new tenants for the 55% space related to these tenants, the situation has potential to deteriorate and affect more senior notes in the transaction," said one market source.

Copyright 2003 Thomson Media Inc. All Rights Reserved.

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